Franco Modigliani's research has been primarily directed
towards household saving and the functioning of financial
markets. The achievements for which Professor Modigliani is now
to be rewarded concern the construction and development of the
life-cycle hypothesis of household saving, and the formulation of
the Modigliani-Miller theorems of the valuation of firms and of
capital costs. These two closely-related achievements both deal
with the management of household property, one referring to total
value, the other to its composition.

The Life-Cycle Hypothesis One of the cornerstones of
the British economist J.M. Keynes' general theory, presented in
1936, is the relationship between consumption and national
income. According to Keynes, it is a "psychological law" that
"households increase their consumption as their income increases,
but not as much as their income increases". One consequence of
this "law" is that the proportion of national income represented
by saving increases during periods of economic growth.

Keynes' theory of saving was generally accepted by his
contemporaries. However, in 1942 Simon Kuznets showed that the theory did
not agree with empirical facts: in the U.S., the long-term
saving: income ratio had not increased over time. This supposed
paradox became the object of a number of studies during the years
that followed, and several new approaches to the theory of saving
were presented. However, it was not until 1957, when Milton Friedman formulated his
"permanent income" hypothesis, that a rational explanation of the
Keynes-Kuznets contradiction was given within the framework of a
general, well-defined theory of consumer demand over time. The
characteristic feature of Friedman's hypothesis is that a
person's income is assumed to consist of two parts, one permanent
and one transitory, and that it is the permanent part that is the
determinant of decisions about consumption and saving. Friedman
argued that Keynes' proposition was incorrect since it was
derived from empirical observations of cross-section data
referring to total, not to permanent, income. Friedman's ideas
were well received by most economists, and for several years the
permanent income hypothesis played a dominating role among
existing theories of aggregate saving.

Three years before Friedman published his theory of saving,
Franco Modigliani, together with Richard Brumberg, a student of
his who unfortunately died some years later, had already
presented the life-cycle hypothesis. Like Friedman, Modigliani
and Brumberg assumed that households strive to maximize their
utility of future consumption. The decisive difference between
the two theories concerns the length of the planning period. For
Friedman, this period is infinite, meaning that people save not
only for themselves but also for their descendants. In the
Modigliani-Brumberg version, the planning period is finite:
people save only for themselves. From the postulate of utility
maximization it follows that consumption is evenly distributed
over time and this, in turn, implies that the individual during
his active period, builds up a stock of wealth which he consumes
during his old age.

The life-cycle hypothesis is a purely microeconomic theory.
However, Modigliani has shown in a number of later works - some
of which were produced in collaboration with others - that the
hypothesis has a number of macroeconomic applications. A few of
these are identical with those of the permanent income
hypothesis, for instance the idea that the aggregate saving ratio
is constant in the long term and that capital gains affect
consumption only slightly. However, some of the macroeconomic
implications differ completely from those of earlier theories.
The most central one is that aggregate savings depends primarily
upon the rate of growth of the economy. Other distinguishing
implications are that aggregate saving is endogenously determined
by economic as well as demographic factors, such as the age
structure of the population and the life expectation; and that an
increase in the rate of economic growth entails a redistribution
of income in favour of younger generations.

The life cycle hypothesis has been used as a theoretical basis
for many empirical investigations. In particular, it has proved
an ideal tool for analyses of the effects of different pension
systems. Most of these analyses have indicated that the
introduction of a general pension system leads to a decline in
private saving, a conclusion in full agreement with the
Modigliani-Brumberg hypothesis.

The underlying idea of the life-cycle hypothesis - that people
save for their old age - is of course not new; nor is it
Modigliani's own. His achievement lies primarily in the
rationalization of the idea into a formal model which he has
developed in different directions and integrated within a
well-defined and established economic theory, and secondly in the
drawing of macroeconomic implications from that model and in
performing a number of empirical tests of these implications.
These achievements are important contributions to economic
science.

The life-cycle model has had a great impact on the development of
later theoretical and empirical research. It represents in fact a
new paradigm in studies of consumption and saving, and is today
the basis of most dynamic models used for such studies.

The Modigliani-Miller Theorems
While the life-cycle hypothesis concerns household saving
decisions, the Modigliani-Miller theorems concern decisions about
aspects of the composition of the accumulated savings stock.
Although closely related, these two subjects are usually regarded
as belonging to two different disciplines: economics and
corporate finance.

Up to the middle of the 1950's, the literature of corporate
finance consisted mainly of descriptions of methods and
institutions. Theoretical analysis was rare. It was not until
Franco Modigliani and Merton
Milier, in 1958, presented their now-famous theorem, and at
about the same time James Tobin
(Nobel Prize 1981) and others started to develop the theory of
portfolio selection, that a scientific theory emerged concerning
the connection between financial market characteristics and the
financing of investments, debts, taxes, etc. Once established,
this theory developed very rapidly.

The first Modigliani-Miller theorem concerns the question of how
the market value of a firm is affected by the volume and
structure of its debts. The central proposition of the theorem
gives a clear answer to this question: neither the volume nor the
structure of the debts affects the value of the firm provided
that the financial markets work perfectly, that there are no
taxes and that there are no bankruptcy costs.

Modigliani and Miller define the value of a firm as the sum of
the market value of the equity stock and the market value of its
debts. Their theorem states that this value is equal to the
discounted value of the flow of its expected future returns,
before interest, provided that the return on investment in shares
of firms in the same risk class is used as the discount factor.
This implies that the value is completely determined by this
discount factor and by the return on existing assets, and is
independent of how these assets have been financed. It further
implies that average capital cost is independent of the volume
and structure of the debts and equal to the expected return on
investment in shares of firms in the same risk class.

In a later paper, Modigliani and Miller formulated another
theorem stating that, for a given investment policy, the value of
a firm is also independent of its dividend policy. A dividend
increase, for instance, certainly increases shareholder's
incomes, but this is neutralized by a corresponding reduction in
share value.

The two Modigliani-Miller theorems hold good, irrespective of
individual differences between shareholders' valuations of risk,
leverage effects, durability of loans, etc. The logic of the
theorems rests in fact upon the assumption of perfect markets,
namely that a shareholder can always, through his own borrowing
or lending, compose his asset portfolio as he sees fit and that
he can, without costs, give it the composition he desires with
respect to risk, leverage, etc. lf for instance the risk level of
a firm's assets is increased, the shareholders can neutralize
this by lowering the risk of other assets in their
portfolios.

The Modigliani-Miller theorems have had important implications
for the theory of investment decisions. One is that such
decisions can be separated from the corresponding financial
decision. Another implication is that the rational criterion for
investment decisions is a maximization of the market value of the
firm, and a third is that the rational concept of capital cost
refer to total cost, and should be measured as the rate of return
on capital invested in shares of firms in the same risk
class.

The Modigliani-Miller theorems represent a
decisive break-through for the theory of corporate finance, and
have had a great impact on later research in this area. Thus the
scientific value of the authors' work is by no means limited to
the formulation of the theorems, but refers to a great extent
also to the introduction of a new method of analysis within the
discipline of corporate finance. While the idea of treating
financial decisions as a market allocation problem is perhaps not
completely new, it was Modigliani and Miller who first used it
for stringent analysis, thereby laying down guidelines for
further research in this area.